fiDucI Y36 AR oTM

inh-anucwry intelligence

fi y6o
January 29, 2007
FOUNDATION FOR
FIDUCIARY STUDIES
Office of Exemption Determinations
CENTER FOR Employee Benefits Security Administration, Room N-5700
FIDUCIARY STUDIES
U.S. Department of Labor
FIDUCIARY ANALYTICS
200 Constitution Avenue, NW.
Washington, DC 20210,

GLOBAL
Attention: IRA Investment Advice RFI
PARTNERS
Ref: RFI Response: Prohibited Transaction Exemption for Provision of
fi36o AUSTRALASIA
& NEW ZEALAND
Investment Advice to Individual Retirement and Similar Plans [published
12/04/20061
fi36o S.E. ASIA &
INDONESIA
Document ID: EBSA-2006-0051-0001

Fiduciary360 (see Enclosure 1 for additional information about "060") is

pleased to submit the following response to question 8 of the above captioned
RFI.

Respectfully submitted,

Donald B Trone, AIFA ®

CEO

438 DIVISION STREET I SEWICKLEY, PA 15143 1 412. 741. 8140 1 FAX 412. 741. 8142 1 fi36o.com


8. How should the Department or a third party evaluate a computer model

investment advice program to determine whether a program satisfies the criteria
described in Question 1 or any other similar criteria established to evaluate such
programs?

Our response is based on the following presupposition:

There is likely to be confusion as to whether a computer model ("model") that meets the
requirements of section 4975 of the Internal Revenue Code ("Code") is intended just to
be used in the development of an IRA beneficiary's asset allocation strategy, or to be
more inclusive and apply to the development of a beneficiary's overall investment
strategy. We believe the latter; the proper evaluation of a computer model also should
include how the model is used in all four steps of a traditional investment decision-
making process.

To illustrate, each of the model criteria ("criteria") described in 4975(e)(1)(B)-(F) of the

Code can be mapped to one of the four steps.

Step One - Organize: What beneficiary input is required, and how does the
computer model obtain and organize the information?

Criteria (b): Utilizes relevant information about the beneficiary, which

may include age, life expectancy, retirement age, risk tolerance, other
assets or sources of income, and preferences as to certain types of
investments

Step Two - Formalize: How does the model formalize the investment strategy,
including the development of the beneficiary's asset allocation strategy, and
prepare a written document that summarizes the beneficiary's inputs and records
the suggested investment strategy provided to the beneficiary?

Criteria (a): Applies generally accepted investment theories that take into
account the historic returns of different asset classes over defined periods
of time

Step Three - Implement: How does the computer model suggest the
implementation of the investment advice, and identify specific investment options
for implementation?

Criteria(c): Operates in a manner that is not biased in favor of

investments offered by the fiduciary adviser or a person with a material
affiliation or contractual relationship with the fiduciary adviser

Criteria (e): Allows the beneficiary, in directing the investment, sufficient

flexibility in obtaining advice to evaluate and select investment options

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 2 of 14


Step Four - Monitor: How does the computer model monitor the beneficiary's
investment strategy? Does it include procedures to periodically rebalance the
beneficiary's portfolio? Prompt the fiduciary adviser to check for material
changes in the beneficiary's profile? And provide investment performance
information to the beneficiary?

Criteria (d): Takes into account the full range of investments, including
equities and bonds, in determining the options for the investment
portfolios of the beneficiary

The evaluation of a model should be based on a flexible doctrine that gives consideration
to incorporating changes in the types of financial products made available to
beneficiaries, as well as evolving investment strategies and theory. At the root of this
doctrine should be the concept of a process standard and the requirement that fiduciary
advisers demonstrate their procedural prudence.

Models provide the fiduciary adviser an additional means for managing investment
decisions, but they still must be evaluated against the backdrop of sound fiduciary
practices. No model is ever inherently imprudent; it is the way it is built and how it is
used that determine whether the prudence standard has been met. While even the most
aggressive and unconventional model can meet the standard if arrived at through a sound
process, the most conservative and traditional one may be inadequate if a sound process
was not implemented.

The following questions are intended to serve as a guide to help the Department, or a
qualified third-party, make a determination as to whether a model meets the criteria of the
Code.

Step One - Organize:

Criteria (b): Utilizes relevant information about the beneficiary, which may
include age, life expectancy, retirement age, risk tolerance, other assets or
sources of income, and preferences as to certain types of investments

1. How does the model determine the beneficiary's risk tolerance?

2. How does the model allow a beneficiary to opt out of an asset class?

3. How does the model incorporate the beneficiary's time horizon until retirement?

4. How does the model incorporate the beneficiary's life expectancy?

5. How does the model overlay the beneficiary's time horizon until retirement with the
beneficiary's life expectancy?

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 3 of 14


6. How does the model calculate the expected return that a beneficiary needs to earn in
order to meet retirement goals?

7. How does the model factor in other sources of retirement income?

Step Two - Formalize

Criteria (a): Applies generally accepted investment theories that take into account
the historic returns of different asset classes over defined periods of time

The development of an asset allocation strategy involves as much art and intuition as
science; and the outputs of a computer model are only as good as the inputs. The old
adage "garbage in-garbage out" has never been more applicable. The challenge for the
expert in evaluating the model is to be able to evaluate the reasonableness of both the
inputs and the outputs.

8. How were the capital markets inputs (expected return, standard deviation, correlation
coefficient) developed for the model?

Simply stated, there are two approaches to developing computer model inputs: (1)
Using the actual historical returns of various asset classes; or, (2) Using historical
returns to then further develop risk-premium inputs. Of the two, the risk-premium
approach is the methodology preferred by most institutional investment
consultants, while the use of historical data is preferred by most broker-dealers.

The problem with using simple extrapolations of recent historical data is that they
are not only likely to be poor estimates of future performance, they also may
cause the computer model to overweigh an asset class that has had recent superior
performance, and underweight the laggards, setting the stage for the classic
investment mistake-buying high and selling low. On the other hand, the
development of risk premium inputs is quite involved, and equally challenging to
evaluate.

9. Are the capital markets inputs reasonable?

There should be no fiduciary requirement; nor should a fiduciary adviser ever

imply; that the computer model is capable of forecasting future returns. However,
there should be a requirement that the expert evaluating the computer model be
capable of easily determining the source of data used by the model, and the
process that was followed in developing the inputs.

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 4 of 14


Enter the capital markets inputs for the model, and compare to those developed by
fi360 (or other investment expert):

to 11360 (4)
Broad Asset Class Standard Comparable Modeled Comparable
Deviation Return to 11360 (,l)
Cash/ Money Market
Short-term Fixed
Income/
Intermediate-term
Fixed Income
Broad Fixed Income/
High Yield
Global Fixed Income
Real Estate
Large Cap Equities
Mid Cap Equities
Small Cap Equities
International Equities
Alternative
Investments/ Other

10. Does the model prepare a written investment strategy for the beneficiary?

See Enclosure 2 for a sample Beneficiary Policy Statement ("BPS"). By reducing

the details to writing and preparing a written investment strategy (PPS), the
fiduciary adviser can: (1) reduce misunderstandings with beneficiaries, (2)
minimize the possibility of missteps by the beneficiary due to a lack of clear
guidelines, and (3) establish a reasoned basis for measuring success, both in terms
of meeting the beneficiary's objectives and the fiduciary adviser's efforts.

11. How is the level of risk communicated to the beneficiary?

The primary function of the model is to demonstrate the probable risk and return
ranges associated with different investment strategies, so that the average
beneficiary can comprehend the risk/return tradeoffs associated with each
proposed strategy.

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 5 of 14


12. How does the model calculate the expected return for a specific asset allocation?

Using the model, calculate the risk/ return profile of the following asset mix:

30% Large cap equities

15% Small cap equities
15% International equities
30% Intermediate fixed income
10% Money market, cash, short-term fixed income

Record Risk: Worse case scenario and/or Standard Deviation

And/or other risk measure

Record Expected Return

If possible, compare results to fi360's Optimizer, utilizing the same asset

allocation
Risk: Model fi360
Return: Model fi360

13. How does the model determine which asset classes should be included?

The following illustration is a suggested guide: Ordinarily, the most appropriate

asset classes to be used as a starting point are the broad market classes
representing the full capitalization-weighted range of investment opportunities.
Simply stated: stocks, bonds, and cash. From this starting point, additional asset
classes and peer groups should be added that provide meaningful risk and return
benefits to the beneficiary's overall investment strategy.

ADDING ASSET CLASSES To AN

IMPLEMENTATION MATRIX

# OF OPTIONS ASSET and SUB-ASSET CLASSES

3 Large Blend, Multisector Fixed & Cash
4 Add International Equity Blend
5 Add Small Blend
6 Add Intermediate Fixed
7 Add Mid-Cap Blend
8 Add Large Value, Large Growth
9 Add Emerging Markets
10 Add Real Estate
11 Add High-Yield Fixed
12 Add International Bond

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 6 of 14


14. Is the model output provided to the beneficiary in a clear and conspicuous manner,
and in a manner the average plan beneficiary can understand?

Step Three - Implement

Criteria(c): Operates in a manner that is not biased in favor of investments

offered by the fiduciary adviser or a person with a material affiliation or
contractual relationship with the fiduciary adviser

Criteria (e): Allows the beneficiary, in directing the investment, sufficient

flexibility in obtaining advice to evaluate and select investment options

15. What due diligence process is used to identify, select, and monitor investment options
utilized by the model?

6360 developed the following due diligence process more than eight years ago,
and believes that it represents the minimum process that should be used to
evaluate an investment option in both the selection and monitoring phases.

Suggested Fields M60 Suggested Threshold Model Defined Implement Monitor

of Due Diligence Threshold (Step 3) (Step 4)
Each investment option should
be managed by: (a) a bank; (b)
an insurance company; (c) a
1. Regulatory oversight registered investment company
(mutual fund); or, (d) a
registered investment adviser.

Each investment option should

have at least three years of
2. Minimum track history so that performance
record statistics can be properly
calculated.

The same portfolio management

3. Stability of the team should be in place for at
organization least two years.

Each investment option should

have at least $75 million under
management (for mutual funds -
4. Assets in the product
can include assets in related
share classes).

At least 80% of the underlying

5. Holdings consistent securities should be consistent
with style with the broad asset class.

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 7 of 14


Each investment option should

6. Correlation to style be highly correlated to the asset
or peer group class being implemented.

Fees should not be in the bottom

quartile (most expensive) of the
7. Expense ratios/ e s
peer group.

The investment option's risk-

adjusted performance (Alpha
and/or Sharpe Ratio) should be
8. Per orinance
evaluated against the peer group
relative to assumed risk
median manager's risk-adjusted
performance.

Each investment option's

performance should be evaluated
9. Per ormance against the peer group's median
relative to a peer group manager return, for 1-, 3- and 5-
year cumulative periods.

10. Other

11. Other

Step Four - Monitor

Criteria (d): Takes into account the full range of investments, including equities
and bonds, in determining the options for the investment portfolios of the
beneficiary

16. How does the model determine the number of investment options presented to a
beneficiary?

There are numerous factors that should be considered in determining the number of
investment options presented to a beneficiary, but no formula can determine the
best number of investment options-the appropriate number, and type, are
determined by facts and circumstances: 1

•
•
Size of the beneficiary's portfolio

•
Investment expertise of the beneficiary
Ability of the beneficiary to properly monitor the strategies and/or investment
options

' Most of these factors were developed by the AICPA's Personal Financial Planning Executive Committee
(Investment Advisory Task Force)

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 8 of 14


• Ease of liquidity
•
•
Minimum required investment

•
The degree to which the investment is diversified

•
Ease in meeting asset allocation and rebalancing guidelines

•
Degree of portfolio transparency

•
Whether portfolio and performance information is audited

•
Degree of regulatory oversight
Ability to give investment direction to the portfolio manager

Does the model facilitate the rebalancing of the beneficiary's account?

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 9 of 14


Enclosure 1: About Fiduciary360 (fi360)

Fiduciary360 (fi360) is the unincorporated identity brand coordinating the resources of

the Foundation for Fiduciary Studies, Center for Fiduciary Studies, and Fiduciary
Analytics. Our mission is to promote a culture of fiduciary responsibility and improve
the decision making process of investment fiduciaries. This includes topics covered in
this RFI.:

The Foundation for Fiduciary Studies is a nonprofit organization established for

the purpose of defining the practices that detail a prudent process for investment
fiduciaries including investment advisors, trustees, and investment committee
members. The Foundation has produced a series of fiduciary handbooks, three of
which served as a basis to the responses in this RFI. Copies of these three
handbooks are included with this RFI. Additional copies are available in a limited
number upon request:

P;U' I rf `. i
I l~ . n I

Investment
Stewar s
Prudent Practices for Investment Stewards (U.S.
Edition) - Defines the fiduciary practices for plan
sponsors, trustees, and members of investment
committees.

!RV, DI >.I

I' H 4~.% Il I , t

Prudent Practices for Investment Advisors (U.S.

Investment
Edition) - Defines the fiduciary practices for Advisors
professionals who provide comprehensive and
continuous investment advice. These practices can
serve as the basis for defining the standard of care
for the PPA's fiduciary adviser and model expert.

Legal
N'lemorandums
Legal Memorandums - Provides the legal opinions
to substantiate all of the fiduciary practices defined
for Investment Stewards and Investment Advisors.

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 1 0 of 14


The function of the PPA's fiduciary adviser represents a melding of traditional

investment fiduciary practices with financial planning. As such, we suggest that the
Financial Planning Association's handbook, Prudent Practices for Fiduciary Advisers,
(as of this date, it is still in draft form) also be referenced in conjunction with this RFI.

The Center for Fiduciary Studies, which is associated with the University of
Pittsburgh's Center for Executive Education at the Joseph M. Katz Graduate School
of Business, provides educational programs on investment fiduciary resonsibility, and
* ®
sponsors the professional designations Accredited Investment Fiduciary (AIF ) and
TM ®
Accredited Investment Fiduciary Analyst (AIFA ). To date, more than 6,000
professionals have gone through the fiduciary training programs.

The AIF is the core course on fiduciary responsibility, and is available on-line or at
various university and professional locations across the country. In 2006 the AIF
designation was named one of the "Ten Most Wanted" designations in the investment
industry by Financial Planning magazine.

The AIFA is the advanced course on fiduciary responsibility which trains professionals to
serve as analysts to assess whether an entity is in conformance with defined fiduciary
practices. The assessment process is based on the global auditing procedures defined by
ISO 19011. We believe that AIFA designees are well-suited to serve as experts, and to
conduct the annual audits of fiduciary advisers.

Fiduciary Analytics is a technology firm which develops Web-based tools, including

models, incorporating fiduciary practices. Though fi360 has experience in building
models, it does not anticipate that it will serve as a vendor of such tools in support of the
PPA.

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 1 1 of 14


Enclosure 2: Sample Beneficiary Policy Statement (BPS)

Step 1 - Organize

Participant Name Date Prepared

Fiduciary Adviser Adviser's Firm

Current Account Balance $ Annual Contribution Amount $

Additional Retirement Benefits:

Defined Benefit Plan $ Spousal Retirement Benefits $

Savings $ Other (Define) $

Step 2 - Formalize (RATE)

Risk Tolerance

Investment Knowledge:

Know a little Know some Know a lot

Risk Tolerance Scale:

I don't want to lose any money

I can take some investment risk

I can take a lot of risk, knowing I also may lose a lot of

money

Asset Class Preferences

Make all of the plan's asset classes available

Restrict the following asset classes:

Time Horizon

Age Years until Retirement

Life Expectancy (actuarial chart) Years in Retirement

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 1 2 of 14


Expected Return

Targeted (Desired) Investment Return

4% 6% 8% 10%

Proposed allocation

Proposed Model Percentage Percentage Modeled Modeled

Stocks Bonds Risk Return
Model A 20% 80% 0 4.0%
Model B 40% 60% -4.0% 6.0%
X Model C 60% 40% -8.0% 8.0%
Model D 80% 20% -12.0% 10.0%

Step 3 - Implement

Suggested Investment Options and Allocations

Fund Name Peer Group Allocation

Mutual Fund A Large Cap Equity 30%
Mutual Fund B Mid Cap Equity 10%
Mutual Fund C Small Cap Equity 10%
Mutual Fund D International Equity 10%
Mutual Fund E Intermediate Fixed Income 30%
Mutual Fund F Short-term Fixed Income 10%

Step 4 - Monitor

Historical Performance (as of Dec 31, 2006)

Fund Name Peer Group 1 Yr 3 Yr 5 Yr

Mutual Fund A Large Cap Equity 3.2% 2.8% 7.4%
Mutual Fund B Mid Cap Equity 3.2% 2.8% 7.4%
Mutual Fund C Small Cap Equity 3.2% 2.8% 7.4%
Mutual Fund D International Equity 3.2% 2.8% 7.4%
Mutual Fund E Intermediate Fixed Income 3.2% 2.8% 7.4%
Mutual Fund F Short-term Fixed Income 3.2% 2.8% 7.4%

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 13 of 14


Moving Forward

Your responsibilities: You must implement the proposed strategy if you believe it is
appropriate.

My responsibilities: I will meet with you on an annual basis to review your PPS, and
discuss whether you need to rebalance your portfolio, make changes to your asset
allocation, and/or change your mutual fund selections.

Plan Participant Date

Fiduciary Adviser Date

Fiduciary360 Response to IRA Investment Advice RFI

January 29, 2007 Page 1 4 of 14